2018-02-03

End of Rally or End of Bull: Is It 1987, 1994, 1997, 1998, 2000, 2007 or 2014?

The ratio bottomed right near the 2008/2009 lows and, as you can see, we’ve seen a continued rise until the middle of 2016. In the years in between a trend line established itself that acted as precise support until the US election. That’s when everything went pear shaped.

Since then the trend line became resistance and the renewed effort to break above it rejected precisely at the trend line again in 2017. Given this history it seems hardly a coincidence, but rather suggests a technical relationship of importance.

Currently we see the ratio dropping hard this week. Why? Because stocks are falling and yields are rising. Which means that for this to move back higher yields must drop and stocks rise. Or at least yields need to stop rising.

But if yields continue to rise and stocks continue to fall the actual pattern of the ratio could be even more alarming:

I follow a chart that uses similar inputs: the Dow Jones Industrial Average versus the 30-year bond futures price.

What jumps out at first glance is the "overbought" reading. Since this is a ratio, it signals the bullish move in stocks versus bonds is at an extreme. Stocks are more overbought relative to bonds than in 1998, 2000, 2007 and 2014. The only period stocks were similarly overbought was in 1987 and the mid-1990s.

In all but one case, stocks either plateaued or declined. Going back and working forward in time:

1987: stocks rally strongly and bonds tumble, leading to the crash.

1994: bonds fall, stocks hold steady, followed by bond and stocks resuming their rallies. The Dow was up only 2 percent in 1994.

2014: stocks plateau, the Dow loses 2 percent in 2015 and bottoms in early 2016, bonds rally until June 2016.

In every case the overbought signal led to lower stock prices. On the plus side, 3 of 7 periods were plateaus or signaled corrections within a bull market. On the negative side, 2 of 7 signaled a market top and 1 of 7 was the run-up to the 1987 crash.

The only "false" signal with respect to stocks was in 1996. Stocks rallied throughout this period and didn't peak until 1998. In every case but this one, you could have exited the market when the overbought signal triggered and re-entered at a lower price. However, it's also the case that if you were too quick to exit in 1987 and 1994 as well, you might have lost money using the signal.

Nevertheless, in every period the overbought signal was followed by a drop in stocks or a rally in bonds.

Moving beyond the overbought signal, there's also a massive inverse head-and-shoulders pattern that completed at the end of 2016. The distance from the neckline to the top of the inverted head points to move to at least 195. At the peak in stocks a few days ago, the move was already 80 percent complete. There's no reason the move has to end at 195, but I'm going to use that as a reference point for discussing various scenarios for this ratio moving forward.

Since this is a ratio, there are 4 ways this ratio chart can move.

How the ratio rises

1. Stocks rise, bonds fall. This is the scenario unfolding since the end of 2016. If the Dow goes to 27,000 and the 30-year Treasury futures dips to 138 that would be a smaller move in bonds than we saw over the past month and its gets the ratio to 195.

2. Stocks fall less than bonds. Stock prices decline amid bond market carnage. Stocks experience a 15 percent correction from the recent high, the Dow hits 22,000. The 30-year futures would have to fall to 112, approximating a yield of around 4 percent. Not the end of the world. This would end the nearly four decades long bond bull market.

Both of these scenarios need not have an end date following a brief corrective period, especially if inflation increases. The ratio has no upper limit because stocks have no upper bound and bonds are stuck within a range of prices. In an expanding economy (factoring in everything including demographics), this ratio should tend to rise over time. The sideways action of the past 17-years indicates a long-term bear market/deflationary period. The move in 2017 represents a generational breakout. The Federal Reserve succeeded in elevating asset prices through the bear market by suppressing yields. Investors may experience sub-par returns in the future because real returns will be below nominal returns. The Goldilocks scenario is inflation slowly moves higher but never becomes a concern. Stocks rise and bonds fall steadily over the next decade, the ratio climbing steadily higher, punctuated by healthy corrections of these trends.

How the ratio declines

1. Stocks fall, bonds rise: This is an easy one to envision: the Dow falls to 18,000, where it was in late 2016. Interest rates fall back towards their lows. This reversal might end quickly because the Fed would cut interest rates and prop up asset prices. Using the ratio as a guideline, it might also be the final bailout and the peak or final lower high of the bond bull market. The 2000, 2007 and 2014 resistance line would become support. The ratio bounces and doesn't look back. A far more bearish scenario could also unfold. Stocks collapse and bonds rally to new highs, a bear market, recession and possibly some form of financial crisis.

2. Stock fall more than bonds. A variant of the 1987 scenario (the 30-year Treasury yield climbed from 7.5 to 9.0 percent ahead of the crash). A bond sell-off creates a chain reaction that triggers a larger event. In percentage terms, a rise to 3.6 percent on the 30-year over a short time period would be the same percentage move as in 1987.

Imagine the dollar slides another 2 or 3 percent and the 30-year Treasury is at 3.6 percent by April. USDCNY would be around 6.1 assuming it continues rising along with the euro. There are already warnings signs out of China that popped up in January as the falling dollar and rising interest rates interact with a Chinese attempt at deleveraging. A bullish variant for U.S. stocks is a repeat of the Asian Crisis. Trouble in China causes a rally in the U.S. dollar and U.S. treasuries, but the U.S. economy escapes the danger and stocks only experience a modest correction.

Conclusion

The Dow-30Y ratio says the current trend of "stocks up, bond yields down" is going to end. It could end because stocks and bonds rally harder or stocks fall, or some other combination, but the current market conditions are running out of time. Only if this is a 1996 scenario are stocks likely to rally, but in that case there will still be some bearish fireworks somewhere.

Longer-term, the H&S breakout signals the bond bull market may be coming to an end. If the Dow-30Y ratio doesn't fail, the ratio goes higher if stock prices rise or bonds are destroyed. If we're still in the post-2008 deflationary period, bonds offer some short-term upside, but little long-term upside. On the flip side, if the Dow falls to 9000, the ratio hits 195 if the 30Y futures is at 46. If a major phase change is underway, the outlook for bonds over the long-term is far more bearish than the outlook for stocks.